ESG PROMISES

ESG PROMISES

“[W]hen faced with a critique of ESG funds, regulators should ask first whether there is an empirical basis for singling out ESG funds or if the purported ESG issue is one that affects the entire fund market.”

JILL E. FISCH, Saul A. Fox Distinguished Professor of Business Law and Co-Director, Institute for Law and Economics

As the Environmental, Social, and Governance (ESG) movement movement continues to expand, Fisch has collaborated with co-authors Quinn Curtis (University of Virginia) and Adriana Z. Robertson (University of Toronto) to conduct a cutting-edge empirical analysis of ESG mutual fund behavior, presenting valuable data to regulators who are increasingly concerned with this sector. “Do ESG Mutual Funds Deliver on Their Promises?” was published in the Michigan Law Review.

The Rise of ESG Mutual Funds

Calls for corporations to be held accountable for the ways in which they contribute to climate change, racial and gender inequity, and supply chain human rights issues have contributed to the rise of the ESG movement.

Investments in mutual funds incorporating ESG criteria have grown significantly, prompting discussion on what it means for a fund to be designated as “ESG” as well as whether such ESG funds charge investors higher fees or deliver lower performance. A broad lack of clarity has raised many concerns, and regulators have signaled interest in enacting rules that would target ESG investment options, ostensibly to protect investors from risks such as greenwashing, inferior performance, and investor confusion.

Regulatory Pressure on ESG Funds

Both the Securities and Exchange Commission (SEC) and the Department of Labor (DOL) have taken initial steps toward more stringently regulating ESG investing.

The SEC has expressed concern that funds with names that signal “green” or “environmental” practices might potentially be giving investors a false impression of their sustainability. Accordingly, in 2020, the agency requested public comment regarding updates to its existing “Names Rule,” which sets standards for the use of certain words in funds’ names. Among the issues on which the SEC requested comments was the Names Rule’s application to ESG funds. Subsequently in May 2022, the SEC proposed amendments to the Names Rule that expand the scope of the 80% policy required by the rule. The SEC also proposed amendments to its regulation of investment companies and investment advisers concerning funds’ and advisers’ incorporation of ESG factors. Among other things, the proposal would create a distinctive taxonomy of funds based on their incorporation of ESG factors.

Participant-directed retirement accounts, such as 401(k)s, are among the largest holders of mutual funds and subject to complex regulations under the Employee Retirement Income Security Act (ERISA) and DOL. Under ERISA, employers must uphold

fiduciary duties and act “solely in the interest” of plan holders when making investment decisions. In recent decades, the DOL has issued increasingly specific guidance regarding a fiduciary’s decision to incorporate ESG factors, guidance that has shifted in accordance with the political values of the administration. Most recently in 2020, the DOL adopted a rule that specifically prohibited fiduciary agents from sacrificing any potential return on investment for non-pecuniary purposes such as ESG. Subsequently the Biden administration announced its intention to not enforce the rule.

These regulatory initiatives have focused their attention on ESG mutual funds and are motivated by the perception that such funds offer distinctive investor protection concerns. This proposition can be empirically tested.

Empirical Analysis

The authors constructed several categories of ESG funds, based on funds’ use of names that suggested a focus on ESG criteria and a list of ESG funds compiled by Morningstar. The authors compared these “ESG” funds to the rest of the mutual fund industry on the basis of their respective holdings, voting practices, costs, and performances.

In evaluating the extent to which an ESG fund’s portfolio differs from that of a non-ESG fund, the authors incorporated ratings from four leading ESG rating providers to construct a fund portfolio’s “ESG tilt.”

The analysis revealed that ESG funds tended to have portfolios with higher ESG scores than non-ESG funds. In examining low scoring ESG funds under the four different ESG measures, the authors found that only two “failed” each of the four tests. Even then, the authors note that the funds’ prospectuses divulged that those funds were intended to be “impact funds,” making it “unsurprising” that the funds invested in companies with lower ESG scores, as the aim was to increase those companies’ approach to ESG criteria over time.

The authors also investigated whether ESG funds generally vote their proxies differently than non-ESG funds. Using data from the ISS’s Voting Analytics database, the authors compared the voting behavior of ESG funds with that of non-ESG funds. As with portfolio composition, the analysis revealed statistically significant differences.

“Although our results do not speak to the question of whether ESG funds vote against management or in favor of shareholder

proposals ‘enough,’ there is compelling evidence that they vote differently from their peers and that a typical ESG fund’s mission involves voting policies as well as stock selection,” the authors write.

Critics have voiced concerns over whether ESG investments incur greater costs or yield lower returns than non-ESG investments. The authors assessed cost in two ways, inquiring whether (1) fees charged by ESG funds are higher than comparable non-ESG funds, and (2) whether the returns ESG funds offer differ systematically from those of comparable non-ESG funds.

Results indicate that ESG funds do not generally cost investors more in fees, generate reduced returns, or provide inferior riskadjusted performance. Funds that merely “consider” ESG principles incur a more complicated analysis.

Implications for Regulatory Policy

The authors’ empirical analysis, although limited to a specific time period, reveals “no glaring evidence of problems in the ESG space.” ESG funds are genuinely different from non-ESG funds and, despite these differences, do not appear to provide investors with an inferior investment option. As a result, the authors argue against ESG-specific regulations, concluding that “[t]he ESG sector of the fund market does not seem to be functioning worse than other parts of the mutual fund industry.”

More significantly, the authors reason that a variety of the concerns flagged by commentators — about investor confusion, higher fees, and the lack of a clear relationship between a fund’s name and its investment strategy — apply to a range of mutual funds, including growth, value, and industry-specific funds. Considering the findings outlined in this article, the authors recommend that, “when faced with a critique of ESG funds, regulators should ask first whether there is an empirical basis for singling out ESG funds or if the purported ESG issue is one that affects the entire fund market.”

In closing, the authors underscore that the results of their empirical analysis “provide no justification for regulatory invention,” and, moreover, “reveal[] that ESG funds do not currently present distinctive concerns [relative to other funds] from either an investorprotection or a capital-markets perspective.”